Fronting arrangements arise in a variety of circumstances involving captive insurance programs. For example, a front may be necessary in an association or other group captive program or where a line such as workers' compensation, commercial auto or a contractual liability policy backing service contracts requires a carrier that is authorized or that has a minimum financial strength rating.
This article examines fronting from the perspective of the captive with an eye towards ensuring that important terms and conditions are built into the agreements governing the fronting arrangement from the outset so the captive and its owners are protected.
Much of the discussion will focus on issues of particular concern to associations and other group programs, but many of the topics discussed also pertain to single-parent captives and reinsurance arrangements in general.
Fronting involves retaining a traditional, authorized insurer -- the "front" -- to write coverage, with some or all of the risk reinsured to the captive. Fronting arrangements can vary considerably from program to program. In some programs, the front may retain a significant portion of the insured risk, reinsuring only a fraction to the captive, perhaps with the captive taking more risk over time as it builds surplus. In other programs, 100% of the risk may be reinsured to the captive from the beginning. Similarly, the front may handle marketing, underwriting and claims functions or some or all of these functions may be delegated to persons affiliated with the captive.1
The principal agreements governing the fronting arrangement are the reinsurance agreement between the front and the captive, any associated trust agreement to secure the captive's obligations under the reinsurance agreement and, where appropriate, a fronting or program agreement.
If the front's role in the program is limited, a fronting agreement separate and apart from the reinsurance agreement might not be necessary. Often, however, it is useful to address issues that do not fit well in the reinsurance agreement in a separate fronting agreement or a comprehensive program agreement. Separating the reinsurance agreement from the fronting or program agreement also allows the terms of the reinsurance to be more easily renegotiated without necessarily opening the rest of the program to renegotiation -- and vice versa.
As a threshold matter, clear and unambiguous language in each of the agreements relating to the fronting arrangement -- and the captive program as a whole, for that matter -- is critical to the program's success. Ambiguous terms in the core agreements can, and with alarming frequency do, come back to haunt participants. This is especially true of the reinsurance agreement, as important aspects of the fronting arrangement can get buried in the arcana of the reinsurance agreement without ever being adequately considered and negotiated by the principals.
In association and other group captive programs, a key concern is protection of the program from unfair competition by the front. A front may have an existing presence in the market served by the captive or may expand into the market at some point. Relationships, proprietary information and intellectual property to which the front is privy by virtue of its participation in the program should be carefully protected. Generally, it is not enough merely to protect the renewals for program business. It pays to set out the parties' rights to all proprietary aspects of the program clearly and precisely in writing.
Another important issue in program business is the flow of funds through the program. Often several accounts will be established to administer the program. It is important to document clearly the relationship among these accounts, what sort of account each will be (e.g., fiduciary), who will control and have access to the account, the schedule for making payments to and from the account, who owns accrued interest, any maximum or minimum funding requirements, reporting obligations and what happens if payments from an account are not made on a timely basis. To minimize credit risk with respect to a front or administrator, it is best to have intermediary accounts swept frequently so that premiums quickly make their way to an account controlled by the captive or a trust account established by the captive.
As mentioned above, key aspects of a fronting arrangement can get lost in the highly specialized terms of the reinsurance agreement at the center of the arrangement. For example, generally the front will require the captive to post collateral for its reinsurance obligations, either in the form of a letter of credit or by collateralizing a trust. Collateral is necessary to protect the front from risk of default by the captive and to allow the front to obtain credit for reinsurance under state regulatory requirements.
Reinsurance trusts have become increasingly popular in fronted programs and other reinsurance arrangements as the cost of obtaining letters of credit has risen in recent years. Two aspects of the terms governing the trust are particularly important. First, the front should be obligated to allow periodic distributions of trusteed assets in excess of the captive's reinsurance obligations. Typically, the threshold above which a distribution may be made is 102% of the captive's obligations. Second, the captive should look for maximum flexibility in the investment of assets in the trust and the ability of its own investment manager to invest and reinvest assets in eligible investments without having to obtain consent from the front each time assets are reinvested.
Especially when long-tail risks are reinsured, the captive may want to negotiate a commutation clause in the reinsurance agreement with the front. Ideally, if new business no longer is being insured by the front, such a clause will allow the captive to force a settlement of the parties' net liabilities so that amounts held as collateral in excess of reserves necessary to run off the business can be released to the captive.
Another important aspect of the fronting arrangement involves responsibility for extra-contractual obligations ("ECO") and losses in excess of policy limits ("XPL"). ECO, as the name suggests, involves awards to insureds, such as punitive damages, that go beyond the terms of the insurance contract. ECO typically arises from a successful claim of bad faith in the handling of a claim. XPL is a type of extra-contractual obligation where the loss is covered under the policy, but the insurer is held liable for loss in excess of the policy limits, usually for failure to accept a settlement that was within the limits.
A fronting insurer, of course, will want the captive to accept responsibility for ECO and XPL. But should it? If claims are adjusted by the front at its own discretion, there is no reason the captive should accept liability for ECO or XPL. If, however, an administrator under the control of the captive adjusts claims, it may be reasonable for the captive to accept responsibility for such losses. Other arrangements are also possible. For example, if the front handles claims, the captive may accept responsibility for ECO and XPL if it is given prior notice of the front's intent to contest a claim and consents to decisions about how the claim is handled.
Other provisions of the reinsurance agreement can seem merely routine at first glance but have important consequences if a dispute arises and the provision is not well drafted. Reinsurance agreements typically include an "offset" provision allowing the insurer (front) and reinsurer (captive) to offset amounts due to one another. Especially in programs where the front, as opposed to an administrator retained by the captive, collects premium, it is important that this clause be tightly worded and not subject to expansive interpretation. Many other standard clauses deserve similar scrutiny.
It is a mistake to assume agreements governing the fronting arrangement will be tested only if the program encounters adversity. In fact, it is often a very successful captive program that will put the relationships among the participants and the agreements underpinning them to the test. For example, the principals of a successful program may feel it appropriate to renegotiate terms or look for new partners, putting existing arrangements under stress. Similarly, a front participating in a successful program may come to see the market segment as a new opportunity, which also can lead to conflict.
Ensuring that the agreements at the center of a program are clear, tightly worded and cover all important aspects of the relationship will help avoid problems down the line. Focusing on the language in the agreements when the arrangement is formed helps the parties (and their advisors) think carefully about the key elements of the relationship and mutual expectations so that uncertainties and misunderstandings can be rooted out and resolved before they become an issue. In addition, clear agreements keep things on track as personnel come and go, memories fade or the environment in which the program operates changes.
When a program is stress-free, the parties focus on the business and their perceived mutual expectations. When significant stress arises, the first question is, "What does the contract say?"
Having a successful fronted program, of course, depends on many things. The agreements governing the program are just one such element. Nevertheless, they are in a real sense a foundation on which a good program can be built, brought to success and kept that way.
Footnote
1. This article does not address state anti-fronting restrictions, which may come into play with some fronting arrangements, depending on the state and how responsibilities for the program are divided between the front and other persons.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
